ECB should be flexible about rates since the economy is down, says Klaas Knot

Klaas Knot, a member of the ECB’s Governing Council and the head of the Dutch central bank, pushed for flexibility in the ECB’s approach to interest rates as the eurozone grapples with economic sluggishness.

Speaking in Washington, Knot made his case for keeping “all options open,” saying the central bank must be able to react to any direction the economy takes. He described the current conditions as highly uncertain, making it essential for the ECB to act as a “hedge” against potential risks to both growth and inflation.

Knot spoke at a conference organized by the Group of 30, an influential think tank featuring former policymakers and financial experts. He pointed out that inflation risks appear to be “more balanced” than before, but he warned that ECB must be prepared to respond if conditions shift.

Despite recent signs of inflation cooling faster than predicted, Knot noted that risks remain. “In the short term, given the downward surprise of both headline and core inflation in the third quarter, we may see inflation dropping faster than expected,” he added.

Diverging views on ECB’s next moves

The ECB recently cut interest rates twice in a row, the first back-to-back reduction since 2011. This has led to open debate among policymakers on whether to go for deeper cuts or to proceed cautiously. 

On one side, there are voices urging the ECB to act more aggressively with steeper rate cuts. On the other, more conservative members are calling for patience, warning that drastic cuts could risk an economic backlash.

Bundesbank President Joachim Nagel, speaking separately in Washington, highlighted the need for caution. He suggested that upcoming economic data will guide the ECB’s decisions in December. Economists and investors are watching these data points, as indicators of economic stagnation across the eurozone raise pressure on the ECB.

According to Knot, the risk of weak growth is looming, with sluggish domestic growth in the euro area adding to the mix. He described this lackluster performance as “slightly puzzling,” given other indicators of a potential soft landing. “We do not foresee a recession in the euro area,” Knot said, though some signs of an economic downturn have started showing.

Inflation expectations and wage concerns

September saw euro-area inflation drop below the ECB’s 2% target for the first time since 2021. While a slight increase in inflation is expected in the coming months, officials believe it will be less severe than initially feared.

Many now anticipate that the ECB’s target could be achieved sustainably by early next year, instead of 2025, as originally projected. Knot expressed hope for this outcome, though he added that economic indicators still present mixed signals.

In recent months, private-sector activity in the euro area has continued to decline, with October marking the second month in a row of downturn. This trend shows no immediate signs of improvement. Consumers, however, are increasingly optimistic about inflation cooling off.

A recent survey by the ECB found that eurozone consumers expect prices to rise by 2.4% over the next year, down from 2.7% in August—the lowest level since 2021.

Over a longer time frame, inflation expectations for 2027 dropped to 2.1%, down from 2.3%, which is the lowest expectation since February 2022.

ECB policymakers remain concerned that higher wages in the labor-heavy services sector could lead companies to raise prices, risking another inflation surge.

Though headline inflation has declined, ECB Chief Economist Philip Lane commented on Thursday that wage growth could slow as inflation levels stabilize. “The catching up motive in wage negotiations is losing ground as inflation normalizes,” he noted.

The balancing act

The ECB’s recent interest rate cuts reflect its attempts to strike a balance between managing inflation and supporting growth. The Bank of France’s governor, François Villeroy de Galhau, explained that risks now exist on both sides of the ECB’s 2% inflation target.

With inflation risks equally likely to miss or exceed the target, he argued that the ECB should continue to relax its monetary policy.

The ECB has already lowered its key interest rate three times since June, each time by a quarter percentage point. But Villeroy suggested that larger cuts could be on the table, should economic conditions warrant.

“We should continue to reduce the restrictiveness of our monetary policy as appropriate,” he said. He pointed to weak private investment and sluggish consumer spending, driven in part by a recent increase in household savings, as further justification for the ECB’s current rate-cutting trajectory.

Villeroy suggested that the central bank would “retain full optionality” moving forward, hinting at possible flexibility in future rate decisions.

Additional reporting by Noor Bazmi